Section 164(2) of the Companies Act, 2013 held to be constitutional: A cause of concern for errant directors?

The Companies Act, 2013 materially altered the manner in which companies functioned in India. In effect, the 2013 Act provided for a more rigorous and strict regime of compliance for companies when compared to the provisions of the erstwhile Companies Act, 1956.

In this regard, the provisions of Section 164(2) of the 2013 Act enumerate two conditions for the disqualification of directors in a company. These are non-filing of annual returns and financial statements, and the non-return of deposits or the non-payment of dividends.

The predecessor of Section 164(2) of the 2013 Act i.e. Section 274 (g) of the 1956 Act also provided for similar conditions of disqualification of directors in events of default with respect to non-filing of financial statements, non-return of deposits or non-payment of dividends. Further, the scheme of the 1956 Act did not envisage the ‘automatic vacation of office’ in situations of default which led to the disqualification of a director from being re-appointed for a period of five years.

However, the 2013 Act, through Section 167, laid down certain contingencies wherein the office of the director of a certain company shall become vacant. Prior to this, the obligatory requirements of filing annual returns and financial statements, if not complied with, led to certain penal and punitive consequences but never the ‘automatic vacation of office’.

Post the notification of the 2013 Act, if a director incurs disqualification under Section 164(2), then the ‘office of the director’ shall become vacant in all the companies wherein the defaulting director holds office, other than the company which is in default.

Over a period of time, various High Courts have on multiple occasions clarified (and in fact encouraged) the scope of Section 274 (g) of the 1956 Act.

In this regard, the Bombay High Court in Snowcem India Ltd. And Ors v. Union of India and Ors, while interpreting and upholding the constitutional vires of Section 274(g) of the 1956 Act held that:

“…Once any person becomes a director, it is his primary duty to ensure that there is proper governance and investors' money is protected...”

In this case, the Court was dealing with the issue of non-repayment of deposits. The final judgement clarified and upheld the intention behind the provisions of Section 274(g) of the 1956 Act. The intention was to disqualify errant directors, protect the investors from mismanagement, ensure compliance and filing of annual accounts and annual returns, increase the compliance rate of filing statutory documents, and infuse good corporate governance in the regulation of corporate affairs.

Similarly, in Saurashtra Cement Ltd. and Ors vs Union of India, the Gujarat High Court reaffirmed the judgment in Snowcem. In doing so, the Court reiterated that the primary object behind the enactment of Section 274(1) (g) of the 1956 Act was to ensure better corporate governance and protect the investments made by the depositors.

Therefore, it seems that the both the High Courts upheld Section 274 (g) by giving effect to the intention of the legislature in wanting to remedy existing norms of corporate governance. However, it has to be borne in mind that these judgments were passed at a time when the courts had to balance the rights of a director and the larger public interest, which extended to the rights of the general members of the public being able to get returns on their deposits and scrutinize the financial documents of a particular company.

In this regard, the balancing act played out by the courts was straightforward i.e. a director is merely in eligible for reappointment for a period of five years after which he may become eligible again notwithstanding other concerns.

However, the scheme of the 2013 Act is wider and it provides for an automatic vacation of the director’s office in the event of there being a default on the director’s part to fulfill her liabilities under Section 164 (2) of the 2013 Act.

This issue, along with a number of other issues, was recently highlighted and clarified in a judgment pronounced by the Allahabad High Court in Jai Shankar Agrahari vs Union of India, which upheld the constitutional validity of Section 164(2) of the 2013 Act.

The Jai Shankar judgment

In this case, multiple writ petitions were filed by directors of various companies who had been declared disqualified by the Registrar of Companies (ROC) for not submitting financial statements of their respective companies for a consecutive period of three years, thereby falling foul of Section 164 (2) of the 2013 Act.

Further, this disqualification was extended to all other companies, irrespective of whether a default was committed qua those companies or not. Accordingly, the ROC had deactivated the respective Director Identification Numbers (DIN) of all the petitioners.

The primary grievance of the petitioners was that no right of hearing was accorded to them before making the declaration of disqualification. Accordingly, the doctrine of audi alteram partem had been violated.

Further, the petitioners were disqualified from serving as directors not only on the boards of the company in default, but also in all other companies wherein they may have been serving as a director. Such a disqualification was made regardless of assessing whether there were any defaults made in complying with the requirement of submitting the various financial statements for that respective company.

Therefore, the petitioners prayed before the High Court that Section 164 (2) be declared as ultra vires the Constitution of India.

The Allahabad High Court, while dismissing the writ petitions, held that the intention of the legislature in enacting Section 164 (2) of the 2013 Act was to make provisions of good corporate governance commonplace. Accordingly, the High Court did not find any merit in the submissions of the Petitioners.

Interestingly, the Jai Shankar judgment clarified that principles of natural justice such as audi alteram partem need not be complied with in all situations. Especially in cases where such disqualification have not been made by a statutory authority but has been by the statute itself. Since Section 167 of the 2013 Act provides for “automatic vacation” when directors have been found to be in breach of Section 164(2), no right of hearing is required. In this regard, the High Court held:

“…In fact no authority under Act, 2013 has been required to make such a declaration. Instead Statute itself makes declaration. The effect and consequence of attracting disqualification is automatic. It requires no order or declaration by any authority. The list issued by ROC of such unqualified Directors is only a ministerial act...”

Accordingly, principles of natural justice need not be read into Sections 164 (2) and 167 of the 2013 Act, before attracting consequences therein. Further, the fact of such defaults taking place consecutively for a period of three years adds to the impression of erring knowingly on the part of the defaulting directors.

Future Implications

All the three judgments mentioned above put forward important clarifications that directors of both private and public companies have to be vary of while managing the affairs of the companies.

Firstly, in upholding the intention of enabling an environment of good corporate governance, the courts have showed an unwillingness to consider excuses in not complying with the requirement of filing financial statements, repaying the deposits accepted by it, and so on. Further, since the Jai Shankar judgment has clarified that the disqualification and subsequent vacation of the respective director’s office is automatic and by way of statute, future interference from courts in such matters is unlikely.

Secondly, all the three judgments imply that repayment of deposits, redemption of debentures, and payment of dividends are on a higher pedestal when compared to the repayment of monies to term-lenders and working capital lenders which are lent to the companies by various banks and other financial institutions.

In this regard, it would seem that since Section 164(2) of the 2013 Act explicitly provides for disqualification in the event of defaults in repayment of deposits, redemption of debentures or payment of dividends, the same was upheld by the courts. Therefore, the courts refused to entertain arguments such ‘as monies being lent by financial institutions may also be traced back to the general public’, since the 2013 Act and its predecessor act did not provide for disqualifications on this basis.

Thirdly, these judgments, along with the provisions of the 2013 Act, may have a cascading effect upon those companies which have common directors. For instance, a director may be at the helm of affairs in a company which is in due compliance with all the requirements of the 2013 Act and the same director may be at the helm in another company which is held to be in default of the obligatory filings and repayments.

In such situations, disqualification and the subsequent vacation of the director’s office may lead to repercussions for companies which enjoy a good commercial standing and goodwill in the market.

Yet, in the wake of rampant corporate fraud and instances of wilful default, these judgments are welcome in holding errant directors to a higher burden in discharging their statutory duties.

Malak Bhatt is an Advocate-on-Record at the Supreme Court of India and founder of the Law Chambers of Malak Bhatt. Atreyo Banerjee is an Advocate who works at the Law Chambers of Malak Bhatt.